Speeches

Flexible Commitment or Inflation Targeting for the U.S.?

Price stability is the primary focus of central
banks, as it should be. Economic theory and recent experience show us that
maintaining a reasonably stable price level promotes long-term growth, helps
economies run more efficiently, and enhances their capacity to absorb exogenous
shocks in the short-run. These benefits arise partly because price stability
helps the marketplace infer changing fundamentals and distinguish them from
transitory disturbances, and partly because it improves the central bank's
ability to conduct effective monetary policy.

Over the past decade or so, a number of central
banks around the world have, to good effect, adopted inflation targeting as a
means of achieving both price stability and credibility as inflation fighters.
The monetary authorities of more than 20 countries, including New Zealand, the
United Kingdom, and Canada have adopted explicit inflation targets.

Over roughly the same period, the Fed has achieved
price stability in the U.S. without inflation targeting. Rather, it has evolved
a less restrictive approach — an approach I call 'flexible commitment.' By
'flexible commitment,' I mean that our current policy's commitment to low
inflation never precludes an active response to economic disturbances. The
Fed's approach has implicitly targeted low inflation, though it does not embody
a numerical inflation target. Moreover, it has been constructive in managing
inflation expectations. Indeed, it has passed a crucial test of any good
monetary policy: it has established the Fed's credibility for maintaining low
inflation.

For over 20 years, the U.S. economy has performed
quite well under this policy regime — dramatically better than it did in
the high inflation environment of the 1970s. In fact, the Federal Reserve's
current approach to monetary policy has done a good job of meeting the Fed's
dual goals of price stability and full employment — goals set by law.

Nonetheless, the idea of creating a framework for
explicit inflation targeting in the U.S. has recently become a topic of
considerable discussion, in this forum and elsewhere. Some have spoken for it,
some against it. The key question is: Could inflation targeting improve on the
U.S. economy's performance going forward?

My position is that inflation targeting makes sense
in principle for the U.S. It is the next logical step on the path the Fed has
been traveling for the past two decades — a path toward greater
transparency and clarity. If properly implemented, it would increase public
confidence in the Fed's commitment to reasonable long-term price stability in
the U.S. It would also strengthen monetary policy as a stabilization tool in a
low-inflation environment. Moreover, while I do not think the U.S. faces a
serious risk of deflation, inflation targeting would also help to avoid this
risk should it arise.

At the same time, I recognize there are several
important issues that must be worked out before an explicit inflation targeting
regime could be established. Two are particularly important. One is calibrating
the inflation target — that is, choosing the target price index, target
inflation range, and target horizon — so as to reinforce, rather than
undermine, the credibility of the Fed's commitment to price stability. The
second is properly reconciling inflation targeting with the Fed's mandate to
foster not only price stability, but also full employment.

As we shall see, these are related issues. We need
to move carefully yet concretely on these two fronts, before we implement
inflation targeting, if we are to realize the promise of better economic
performance. With proper implementation, inflation targeting makes sense for
the U.S. — in practice as well as in principle — and I would support
it.

The Canadian Experience with Inflation
Targeting

Our neighbors to the north speak well of explicit inflation
targeting. In Canada, the economic boom at the end of the 1980s, together with
an oil price shock and the introduction of their goods and services tax, led to
fears that inflation would escalate. Against this backdrop, the Canadian
government and the Bank of Canada agreed on explicit targets for inflation
reduction in 1991.

The first formal targets aimed to bring inflation
down to 2 percent by December 1995. Inflation declined more quickly than
anticipated and was already closing in on its target by January 1992 —
almost four years ahead of schedule. Since then, with year-over-year inflation
almost always in the 1 to 3 percent target range, the policy has been widely
regarded as a success. Moreover, the Bank of Canada and many academics contend
that inflation targeting contributed to the country's improved economic
performance.

Interestingly, the major lesson drawn from the
Canadian experience with inflation targeting relates to credibility and
inflation expectations. After inflation fell to 2 percent, expectations began
to closely track the announced inflation target. With the low inflation target
becoming increasingly credible, the nature of inflation in Canada began to
change. During the 1990s, inflation became less responsive to short-run supply
and demand excesses as well as to relative price shocks. Canada also enjoyed
increased stability in its real economy. As compared to the preceding decade,
the first decade of inflation targeting showed less volatility in both output
growth and the unemployment rate. In short, inflation targeting worked as an
automatic stabilizer in response to a whole range of economic disturbances.

The Canadian experience points to the potential
benefits of explicit inflation targeting in the U.S. It suggests that
institutionalizing an explicit target, by adding precision to inflation
objectives and thus enhancing the transparency and accountability of central
bank policy, can both stabilize prices and improve overall economic
performance.

However, a U.S. shift to an inflation targeting
regime would entail important implementation issues unique to our environment.
We would be implementing inflation targeting after having achieved price
stability and credibility. Other countries implement inflation targeting as a
means to achieve those objectives. Moreover, inflation targeting in the U.S.
must recognize the Fed's dual goals of price stability and maximum sustainable
economic growth. Unlike the Federal Reserve, many inflation targeting central
banks have a single mission of price stability.

These implementation issues are more than technical.
They lie at the core of how such a system might effectively work in the U.S.
context. Let me elaborate.

The Current U.S. Policy Framework

While
the Fed has not adopted explicit inflation targeting, the policy strategy it
has followed over the past 20 years generated many of the benefits inflation
targeting offers. The Fed greatly increased its credibility for maintaining low
and stable inflation and achieved an enviable record of output growth. It
became more proactive in heading off inflationary pressures, even as it sought
to ensure continued growth by responding aggressively to financial shocks and
demand variations. At the same time, the Fed has become increasingly
transparent — an important component of maintaining a credible commitment
to low and stable inflation.

My colleague Fed Governor Ben Bernanke has described
the current policy framework as 'constrained discretion.' But, as I mentioned,
I prefer the term 'flexible commitment.' Under flexible commitment, the central
bank has been free to adjust monetary policy to stabilize output and employment
during short-term disturbances, while maintaining a strong commitment to
keeping inflation under control.

Flexible commitment incorporates the idea that low
and stable inflation is a key outcome of successful monetary policy. Yet, it
has not offered an explicit inflation target, nor has it reported
quantitatively on our successes or failures. Nonetheless, the Fed has achieved
what is essentially price stability and also has stabilized inflation
expectations.

The Philadelphia Fed's Survey of Professional
Forecasters clearly confirms well-anchored long-term inflation
expectations. In 1991, we began asking survey participants for their 10-year
inflation expectations. The median forecast was that CPI inflation would
average 4 percent over the next 10 years. As core inflation declined, inflation
expectations declined along with it. Declining inflation expectations are one
reason we were able to achieve remarkable economic growth in the 1990s even as
trend inflation slowed to its lowest level since the early 1960s. In 1999, our
survey's 10-year CPI inflation expectation settled in at 2 1/2 percent. It has
stayed there ever since. The Fed's aggressive actions to lower the federal
funds rate in 2001 and 2002 did not elevate our survey participants' long-run
inflation expectations. The recent dip in core inflation did not diminish them.
I take this as a positive sign that the Fed's commitment to maintaining
reasonable price stability is a credible one in the mind of the public.

This stabilization of expectations is crucially
important. Indeed, recent history suggests the commitment to long-run price
stability has enhanced the Fed's short-tun flexibility to respond to shocks, as
well as monetary policy's effectiveness in offsetting shocks. Because the Fed's
aggressive actions to lower the federal funds rate in 2001 and 2002 did not
elevate long-run inflation expectations, long-term interest rates came down
with short-term interest rates. Clearly, the decline of both long- and
short-term rates helped stabilize the economy.

But we have not always been successful. Recall the
1970s. Early in the decade, inflation began to rise, and the Fed failed to
establish itself as a champion of price stability. The public's inflation
expectations became unstable. Inflation and inflation expectations spiraled
upward. Economic performance deteriorated. The Fed, concerned about the
potential impact on employment and economic activity, initially avoided
undertaking the strong policy actions necessary to break this destructive
cycle. It was not until Fed Chairman Paul Volcker led the economy into
disinflation in 1979-82 that the Fed began to regain credibility.
Unfortunately, regaining credibility was costly. We suffered two recessions
during those years.

Should We Move to Inflation Targeting
Now?

Under both Chairman Volcker and Chairman Greenspan, the Fed worked
hard to restore low and stable inflation. Their efforts proved successful in
giving the Fed credibility as an inflation fighter. This was done using the
strategy that I described as flexible commitment — one with an implicit
objective of price stability rather than an explicit inflation target. In the
face of well-anchored inflationary expectations, the question now is whether
this is the time to adopt an explicit target. In an environment where we have
already achieved credibility, should we institutionalize it?

I believe a properly specified inflation target can
help ensure the continuation of our recent success. It can protect us from
repeating the mistakes of our past without unduly constraining our ability to
respond to short-run shocks. An explicit inflation target would place some
check on Fed actions, helping to lock in the Fed's hard-won credibility. But we
must recognize that inflation targeting in the U.S. might differ from the
systems used abroad for two reasons: (1) the U.S. has already achieved price
stability, and (2) the U.S. has the dual goals of price stability and full
employment.

Nonetheless, we can learn from other countries'
successful experience as well as from the academic literature on this subject.

The Academic Literature on Inflation Targeting
and Credibility

One key lesson of the academic literature is that, in
theory, inflation targeting is the best strategy for achieving both Fed policy
objectives: low, stable inflation and full employment. Indeed, it is difficult
to write down a macroeconomic model that does not lead to some sort of
inflation targeting as the optimal monetary policy approach for achieving these
two goals. Not surprising, given that more-than-transitory deviations from full
employment will, with a lag, mean changing inflation.

Another idea emphasized by theorists is that of
transparency. The Federal Open Market Committee (FOMC) recognizes that
transparency plays an important role in achieving our policy objectives and
goals. Any policy action can have very different effects, depending on what the
private sector infers about the information that induced policymakers to act,
about policymakers' objectives, and about their likely future actions.
Accordingly, FOMC statements have been made more explicit and more direct.
Votes are now released at the end of meetings, and forums such as this offer an
opportunity to share thinking and explore nuances in policymakers' views.

Greater transparency in policymaking, along with a
commitment to reasonable long-run price stability, has enhanced Fed
credibility. As I mentioned earlier, credibility has given the Fed greater
flexibility to respond to economic and financial shocks. The benefit of
transparency and credibility is evident in the recent movement of the fed funds
rate to a 40-year low. A 525-basis-point reduction in the funds rate with no
damaging rise in inflationary expectations would have been unimaginable 20
years ago.

The positive results of this approach to monetary
policy are evident. The documented decline in economic volatility in the
mid-1980s occurred at the time the Fed conquered inflation, started achieving
credibility for lower inflation, and brought inflationary expectations under
control. While I do not believe better monetary policy is the entire story, it
certainly played an important role.

If implemented carefully, explicit inflation
targeting can reinforce the effectiveness of monetary policy. It would enhance
our transparency, make it easier for the public to understand monetary policy,
and further improve expectations dynamics.

We know that public perceptions about longer-run
monetary policy impact the effectiveness of short-run policy actions.
Specifically, the effectiveness of current monetary policy is influenced by
expectations of future policy actions and expectations of long-term inflation.
Inflation targeting would anchor these expectations more firmly, making price
stability easier to achieve in the long term, and increasing the central bank's
ability to stabilize output and employment in the short-term. Explicit
inflation targeting in the U.S. might also deliver a more lucid explanation of
policy, reduced uncertainty in financial markets, and increased popular support
for the Fed. The interaction between credibility and policy actions is a key
ingredient to implementing effective monetary policy. Proper implementation and
design are therefore crucial if explicit targeting is to fulfill its promise.

Inflation Targeting as the Potential Next Step

Inflation targeting would be an evolutionary, rather than a
revolutionary, step in the Fed's policy strategy. Against the background of
'flexible commitment,' as I have described it, the Fed could simply quantify
what it means by price stability — a goal it has been pursuing for almost
a generation and, most would agree, has now achieved. The Fed would then
include in its regular testimony before Congress a report on its success or
failure to achieve that numerical target. These steps would move the Fed
farther along the path to greater transparency and accountability — a path
along which it has already been moving.

But to say inflation targeting is an evolutionary
step is not to say it is an easy one. Simply announcing a numerical target is
not enough. A number of important implementation issues are essential to the
success of inflation targeting in the U.S. Given our nation's already low and
stable inflation rate, these issues are more substantive for us than they would
be for a country experiencing high inflation. If we are to coax out additional
gains from being explicit, we must pay careful attention to the design of the
targeting framework.

An inflation target has to be calibrated in terms of
three components: an inflation measure; a target range; and a time period over
which average inflation is to fall within that range. Given the Fed's dual
mandate to achieve price stability and full employment, we need to consider
carefully several issues relevant to the choice of components for an inflation
target.

The first issue is this: It is widely accepted that
pursuing policies to stabilize output and employment in the face of temporary
shocks can create greater short-run variance in inflation. So how does the Fed
set an explicit range for an inflation target that is firm enough to impart
credibility to its long-run price stability goal, yet flexible enough to
accommodate its short-run stabilization goal?

Research suggests that central banks face a
quantifiable short-run tradeoff between the variance in inflation and the
variance in economic activity (output and employment). Thus, to properly and
optimally implement inflation targeting, we must allow for some variability in
inflation.

This means that inflation would equal its targeted
value only on average. The question arises over what time frame should we
measure that average? A second question is how much variability should we allow
around the average? Of course, the answer will depend on the time frame. A
two-year average can be targeted more precisely than a quarterly average. Thus,
implementation is likely to require a target range and time horizon pair.

The particular pair the FOMC selects must hinge on
practical considerations, such as information lags and the underlying
volatility of economic disturbances, along with our understanding of how the
economy works. The target range/time horizon pair may be subject to change, but
only infrequently. For explicit targeting to improve on our current procedure,
the target horizon and target range must be set in a way that enhances both
credibility and performance.

The second issue relevant to the implementation of
inflation targeting is this: The target range/time horizon pair, to some
extent, will influence the Fed's flexibility in reacting to shocks. In a
perfect world of full information and complete credibility, everyone would be
able to discern the Fed's optimal response and observe whether it has followed
through. But this is not a perfect world. Maintaining credibility will require
adherence to the target range/time horizon specification, which could impose
some constraints on flexibility. Thus, a careful consideration of how best to
set our targets is required to carry out our dual mandate.

Similarly, the occurrence of an improbably large
shock could make hitting the target range technically impossible or extremely
costly. In such cases attempting to maintain the targeting regime may not be
socially desirable.

At times, there may be a temptation to re-contract
by changing the components of the inflation target, or by temporarily relaxing
its parameters. But such re-contracting would erode credibility and leave us
with less effective monetary policy than we have achieved thus far. So I
believe that careful design is important if explicit inflation targeting is to
prove effective.

Finally, there is a third issue surrounding the
implementation of inflation targeting by the Fed. Again, it emanates from the
Fed's dual mandate to achieve price stability and full employment. This time it
is the issue of symmetry. If the Fed sets an explicit inflation target, will
the public then expect the Fed to establish explicit targets for other economic
variables as well?

From an economist's point of view, this kind of
symmetry would not be reasonable. Long-run inflation is under the control of
the central bank. Potential GDP growth and the natural rate of unemployment are
not. Further, the central bank can target only one variable and that variable
is long-run inflation. While we believe that reasonable price stability, by
which we mean low and stable inflation, is a necessary condition for achieving
maximum sustainable growth and full employment, the central bank must take the
long-run values of other variables as given.

Nonetheless, recognizing the Fed's capacity to
conduct countercyclical monetary policy, we might argue that the Fed should
establish near-term targets for real growth or unemployment. However, in the
real world of daily ups and downs, it would be difficult, if not impossible,
for the Fed to keep such variables within some meaningful range.

I believe that establishing dual numerical targets
would be a mistake, even though the Fed has dual goals. Trying to establish
numerical targets for both inflation and real growth or unemployment would
almost surely end up undermining, rather than reinforcing, the Fed's capability
to achieve price stability and conduct effective countercyclical policy.
Accordingly, if inflation targeting were deemed likely to fuel calls for
targeting other macroeconomic variables, I would not endorse it.

In short, I am in favor of inflation targeting in
principle. However, I strongly believe we must address the implementation
concerns I set forth before moving to an explicit inflation target.

Inflation Targeting vs. Price Path
Targeting

Before closing, I want to discuss an important difference
between two explicit price stabilization strategies currently being debated in
the academic literature — inflation targeting and price path targeting.
The two terms are often used interchangeably in the popular press, but the
distinction between them is important.

Stated simply, inflation targeting targets the rate
of inflation. Under an inflation targeting regime, if inflation rises
temporarily above target, it must then be brought back down. However, the price
level remains permanently above its targeted level. Price level targeting, by
contrast, means that any deviations from the prescribed price level path must
be offset in the future so as to return the price level to its target value.
Thus, price level stability is more rigid and less forgiving than inflation
targeting.

Recent research has suggested price path targeting
may achieve better economic outcomes in an environment of zero-inflation or
deflation. This, I presume, is one reason that Governor Bernanke recently
suggested the Bank of Japan adopt a price-level target.

It has been argued that when inflation is very close
to zero and demand is weak, price path targeting is more effective than
inflation targeting in staving off deflation. Suppose inflation falls below
target in the current period. Under inflation targeting, the price of goods and
services today does not change relative to their expected future price. But
under price path targeting, the lower price level today makes goods and
services cheaper today relative to their expected future price. This encourages
consumption and increases demand today. Also, firms — knowing that prices
will be a lot higher later — would be less likely to cut prices. Both
effects mitigate the dangers of deflation.

By design, price path targeting is much more
constraining than inflation targeting. Deviations in the price level due to
external shocks of any kind must be offset in order to achieve the target price
level at some pre-determined point in the future. The costs of doing so are not
considered. But in actuality, such a policy regime is likely to lead to more
pressure for relaxing the parameters of the target than an inflation targeting
regime. This alone would undermine stability of the policy regime and in the
long run reduce its credibility. For this reason, I cannot advocate price path
targeting for the U.S. at this time.

Nonetheless, research on price path targeting is
still in its early stages. And we have no empirical evidence on how effective
it would be in comparison to inflation targeting. Accordingly, I do find this
research interesting and worth pursuing, at least at a theoretical level.

Conclusion

To conclude, I believe the FOMC
should seriously consider inflation targeting. I would like to see work on
implementation issues begin so that we may consolidate the gains made by
flexible commitment and increase the efficacy of policy even further.

Some have suggested our recent success in achieving
price stability speaks against implementing inflation targeting. The U.S.
economy has been able to realize price stability and anchor inflation
expectations under a policy of flexible commitment. Why change now?

I believe that we have reached a point where
institutionalizing inflation targeting simply makes good sense from an economic
perspective. In short, it is a reasonable next step in the evolution of U.S.
monetary policy, and it would help secure full and lasting benefits from our
current stable price environment. Evolving to explicit inflation targeting from
our current implicit target has significant potential benefits, and the costs
may be minimal if we can implement it in a constructive manner.

Clearly, proper implementation of inflation
targeting is crucial to its success. That, in turn, requires more research and
analysis. It also requires more public debate and discussion. The Money
Marketeers are among the leaders in providing a forum for that public debate
and discussion. Thank you for inviting me to participate. Now I'll be happy to
take your questions.

References

Bernanke, Ben. Remarks at the
Annual Washington Policy Conference on the National Association of Business
Economists, Washington, D.C., March 25, 2003.